Do brokers earn a profit on commission-free trades?

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natureexplorer
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Do brokers earn a profit on commission-free trades?

Post by natureexplorer » Sat Jan 30, 2010 12:48 pm

Do brokers earn a profit on commission-free trades?

For example, if I buy an ETF at Wells Fargo with one of my 100 free trades, do they still earn a profit on such a trade?

I understand they might make money on cash in the money market account or by cross selling, but do they make money on the actual trade transaction?

In the Bogleheads Guide to Retirement Planning book on page 130 it says the following:
However, no-commission trading is not the same as no-cost trading. These brokers often earn a handsome profit from the trading spread and reciprocal trading agreements with other brokerage firms.
(my bold)

Is this true? If yes, how does this work?

dumbmoney
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Post by dumbmoney » Sat Jan 30, 2010 4:17 pm

I am pleased to report that the invisible forces of destruction have been unmasked, marking a turning point chapter when the fraudulent and speculative winds are cast into the inferno of extinction.

eurowizard
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Post by eurowizard » Sat Jan 30, 2010 7:37 pm

Perhaps the 100 free trades must be executed online without the assistance of a broker?

If not, then perhaps WF still gives broker's their commissions, and then considers this expense. Thus, the value of you keeping $25k+ at the company is worth the commission expense of 100 free trades.

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natureexplorer
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Post by natureexplorer » Sat Jan 30, 2010 8:06 pm

dumbmoney, thanks!

I am a little in shock about my broker, Wells Fargo in this case, apparently being allowed to control the flow of my orders - thereby potentially delaying execution of my order or maybe even no execution because I was not given the opportunity to trade with another uninformed trader.

Does the order flow manipulation affect the price negatively for the retail investor like the Boglehead guide suggest? It sounds like this is like a hidden commission.

Does anyone know whether Wells Fargo accepts payment for order flow? Does this apply only to NYSE or other US exchanges?
eurowizard wrote:Perhaps the 100 free trades must be executed online without the assistance of a broker?

If not, then perhaps WF still gives broker's their commissions, and then considers this expense. Thus, the value of you keeping $25k+ at the company is worth the commission expense of 100 free trades.
Why would it make a difference if the order put in online or otherwise?

dumbmoney
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Post by dumbmoney » Sat Jan 30, 2010 9:00 pm

It's not as bad as it sounds. The market maker can't give you a worse price than what somebody else is offering.
I am pleased to report that the invisible forces of destruction have been unmasked, marking a turning point chapter when the fraudulent and speculative winds are cast into the inferno of extinction.

livesoft
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Post by livesoft » Sat Jan 30, 2010 9:15 pm

I doubt WF makes any money off the free trades on most sane transactions. I can enter an order at WF and then use TDAmeritrade to watch it execute in real time. I have not noticed any shenanigans.

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natureexplorer
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Post by natureexplorer » Sat Jan 30, 2010 10:19 pm

dumbmoney wrote:It's not as bad as it sounds. The market maker can't give you a worse price than what somebody else is offering.
But why does it result in a cost to the retail investor then?
no-commission trading is not the same as no-cost trading.

livesoft
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Post by livesoft » Sat Jan 30, 2010 11:24 pm

I think your bolded phrase earlier in the thread is mostly wishful thinking of the author.

Here's where I see the costs of trading with a no-commission broker:
1. Low interest on the cash-sweep account.
2. Bid/ask spread
3. Premium/discount to NAV
4. Expense ratio(s) of any ETFs you might own

I imagine that the broker can capture the spread if they sell to you the shares that another client is selling. That is, they can act as market maker sometimes.

The premium/discount to NAV is not much of concern to me. And anybody who uses a fund whether ETF or open-end share class has to expense ratios to deal with.

In short, the folks who diss ETFs probably are biased against them for invalid reasons.

xerty24
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Post by xerty24 » Sun Jan 31, 2010 3:03 am

natureexplorer wrote:
dumbmoney wrote:It's not as bad as it sounds. The market maker can't give you a worse price than what somebody else is offering.
But why does it result in a cost to the retail investor then?
The cost isn't for the retail market orders... it's for your retail limit orders that won't ever get hit by "dumbmoney's" market orders because the market maker intercepts them and fills them himself at a tiny price improvement.

I will also point out that the broker has to pay extra exchange fees when their customer places a market order, which you the customer aren't charged for. (They also get a small rebate when you place a limit order, if it is filled, but this is smaller than the expense)

MrWinky
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Post by MrWinky » Sun Jan 31, 2010 12:51 pm

I would think that giving out free trades and then lending your cash to margin accounts is a huge net win. If you already are a bank, lending your cash to homeowners is an even bigger net win...

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natureexplorer
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Post by natureexplorer » Sun Jan 31, 2010 1:36 pm

Xerty24, thanks for the explanations. It seems like this cost is difficult to quantify since it will vary from trade to trade. Most of my orders are limit order to avoid something funky to happen.

xerty24
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Post by xerty24 » Sun Jan 31, 2010 2:06 pm

natureexplorer wrote:Xerty24, thanks for the explanations. It seems like this cost is difficult to quantify since it will vary from trade to trade. Most of my orders are limit order to avoid something funky to happen.
The costs depend on if you are on the active or passive side of the trade. If you put a limit order to buy higher than the ask, you are the active side even though you use a limit order. Alternatively, if you put a limit order to buy lower than the best ask, and you eventually get filled, then you are the passive side. Depending on a lot of details, active trades cost about 1/3 of a penny to the broker, while passive trades earn about 1/4 of a penny (per share).

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